Basel 3: where will it all end?

Despite many observers and media channels accusing regulators and politicians of 'fiddling while Rome burns' over the Eurozone sovereign debt crisis, further developments on prudential regulation and capital requirements continue to emerge for the banking industry to digest.

While Basel 3 is agreed internationally and the Basel Committee's Deputy Secretary General Bill Coen has been at pains to point out that "these are rules and not proposals like the press sometimes likes to make out"1, many areas have yet to be finalised and further developments continue to emerge.

In Europe, Basel 3 is to be implemented via the Capital Requirements Regulation which applies to the letter in each jurisdiction and an amended Capital Requirements Directive, collectively known as 'CRD 4' which is subject to national implementation; however, at the time of writing this remains at the consultation stage, leaving little time for implementation ahead of the 2013 deadline. In the US, a recent speech by the Federal Reserve Governor Daniel Tarullo confirmed the move forward there, albeit with the tricky problem of how to deal with the inbuilt reliance on credit rating agencies within the current prudential regulatory regime.

Not content with waiting for this to be digested, recent weeks have witnessed a further torrent of regulatory proposals, including Basel Committee proposals to address globally systemic banks, the Financial Stability Board's (FSB) proposals on recovery and resolution plans, the European Commission's proposals on MIFID2 and the Market Abuse regime.

Whilst there remains a focus on capital, regulators have continued to examine their full range of options and there is a lot still to do to ensure the new liquidity regime is 'fit for purpose'. Fundamental areas of debate, discussion and discontent remain in some quarters, including:

In Europe, the role of the European Banking Authority (EBA). CRD 4 is firmly aimed at eliminating areas of national discretion in the prudential regulations, whilst putting the onus on the EBA to develop binding standards in approximately 150 separate areas. While some in the UK see this as the 'thin end of the wedge' towards a single European regulator, at the very least it represents a considerable and challenging workload for what is still a fledgling organisation with a limited number of staff? It will be interesting to see over time how the EBA responds to this.

Central counterparties (CCPs). Responses to crises typically spawn a whole raft of apparently brand new acronyms and buzz-words; "macro-prudential" and "CCPs" are but two notable examples. In the case of CCPs, it should be noted that financial historians (yes they do exist) cite the existence of CCPs for several hundred years going back to the days of commodity clearing houses. They are the less glamorous parts of the post-trade infrastructure, in other words the back-office. Policy makers have seized on them as the panacea to all ills in the Over The Counter (OTC) markets. The Basel Committee recently published a second consultation paper2 for how banks' exposures to CCPs will be treated; it remains to be seen how this cascades through into the EU's CRD4. While there are undoubted benefits of CCPs, such as increased netting between multiple parties, increased data and tracking of exposures and trades, and mutualisation of losses, risk is undoubtedly being concentrated on a few very key components within the financial system. If the bodies tasked with ensuring the CCPs are adequately capitalised, and risk managed, fail to do their jobs properly, the end result may simply be a different set of 'too big to fail' entities.

Systemically Important Financial Institution (SIFI) surcharge. The Basel Committee's rules to address the 'too big to fail' regime set out an 'indicator framework' for determining how systemic an organisation is and then an increased capital buffer which will be applied to such firms. Taking what they describe as an 'LGD approach ' to dealing with systemic firms, they require a surcharge or buffer to be held in Common Equity. This is contrary to the hopes of many organisations which will see it as yet another burden at an already very difficult time.

Expected loss loan provisioning. The International Accounting Standards Board (IASB) is making what appears to be heavy going of introducing an expected loss-based approach to provisioning as they are compelled to do by the post-crisis G20 declarations. The Basel Committee appears to be losing patience, and it would not be surprising if there isn't an approach whereby global regulators set out a framework for regulatory provisioning in prudential matters (similar to how some countries such as Spain and South Africa have historically done things) which would be different from the accounting framework.

Non-equity capital. Regulators have focussed directly and indirectly on trying to get firms to raise more equity capital. The rules on eligibility for new non-common equity tier 1 capital are strict around mechanisms to absorb loss at the point of non-viability. However, requirements around write-down or automatic equity conversion raise concerns around the traditional ordering of the capital structure, pricing and whether there is an investor base for such products.

The list could go on, covering the fundamental review of the trading book (will we continue to see a two-tier approach?), attempts to reduce the dependency on external rating grades within the securitisation framework, enhancements to stress-testing arrangements, the blunt tool that is the counter-cyclical capital buffers and how it will work in practice when or if the next boom arrives. Will the leverage ratio drive the behaviour that policy-makers want, and is the CVA charge still double-counting?

Conclusion

So, there is certainly lots for regulators, policy-makers, the industry and advisers to consider. One thing is for certain however: banks, and banking activity, are both essential for the economic growth that is required to shake the global economy out of the current malaise. Any regulatory reform, particularly if focussed on capital in the way that Basel 3 / CRD 4 is, must balance the need for increased safety and stability with the other side of the equation which can see organisations meeting enhanced capital requirements through shrinking their balance sheets by reducing lending to the real economy. That is something no one associated with or involved in the industry would wish to see.